Learn
Timely and correct identification of trend reversals can help traders enter positions at the right time or exit positions before the market moves against them.
Accurately identifying reversals is the most critical skill to build for trend traders. Reversals are both the perfect entry and exit points. If you’re already trading a trend, the early identification of a reversal can help you lock in gains and prevent losses when the market changes direction. Since a reversal marks the beginning of a trend in the opposite direction, some traders may consider this as the right time to enter an asset and ride that direction in price movement. Here’s a look at the common trend reversal patterns, their timing, and how to identify them.
Identifying reversals is key to successful trend trading. Here are a few things to keep in mind to make the right decisions regarding your trade set-ups:
There’s always some degree of volatility in the markets. However, not all price changes are reversals. Small countermoves against the trend could be pullbacks and may not indicate a trend reversal, which is what happens when the bulls or bears have lost control, causing a change in the direction of the market. Exiting on a pullback can reduce the returns from a winning trade. Studying historical charts will give you an idea of how the asset typically behaves and whether a price movement is a pullback or marks the beginning of a reversal.
Since the duration of a pullback is short, you may wait it out till a reversal takes hold.
Reversals can occur during the span of a day, and even over weeks or months. These reversals are relevant to different traders. If you’re a long-term trader, reversals in a single day may not matter to you. If you’re an intraday or day trader, reversals in the minute or hourly charts will be important.
Given that candlestick charts convey much more about the market, they allow you to identify reversals and extensions more accurately than other chart types. This is why algorithmic trading also uses these to spot signals.
Some popular candlestick reversal patterns are:
This unique reversal pattern is created by three peaks of the price. The two peaks on the sides are usually of similar height (known as shoulders), while the one in the middle is the highest (known as head). This pattern is used after a significant uptrend, while the opposite head and shoulder is used after a downtrend.
Once a head and shoulder pattern is formed, the three bottoms of the three peaks are joined together to form a neckline. The moment the price breaks this neckline, it is considered as a reversal signal. You can take a sell position after an uptrend or go long after a downtrend.
While most traders place their stop loss above the right shoulder when an uptrend reverses, experienced traders calculate the stop loss based on the pips of the last swing high.
During an uptrend, if three peaks are formed that are almost the same height, it is considered a sign of reversal. This formation indicates that the buyers may be running out of steam. When this happens, you need to keep an eye on the trigger line, which is the last bottom between the second and third peaks. The price breaching the trigger line is an indicator to go short.
Similarly, during a downtrend, three bottoms forming indicates that bears are losing power. When the price breaks out of the trigger line, which is the top between the last two bottoms, you can consider opening a buy position.
The occurrence of a pin bar or hammer in a downtrend signals the start of a rally. Similarly, the occurrence of an upside-down hammer, known as the shooting star, during an uptrend signals a potential reversal to the downside.
A bullish engulfing candlestick indicates a possible reversal of an uptrend. This is a bullish candlestick that has a close higher than the open and completely encompasses the body of the preceding down candlestick. The bearish engulfing candlestick signals the beginning of a rally in the market.
You can enter a position after the engulfing candlestick has closed while placing the stop loss below the low of the engulfing candlestick.
This pattern, identified by Mark Fisher in his book The Logical Trader, provides an early signal of a possible change in trend. The main feature is that it comprises multiple (usually ten) bars in which the first five are confined in a narrow range of highs and lows, while the latter five engulf the former with a higher high and lower low. The first five bars are known as “inside” bars and the latter ones are known as “outside” bars.
The pattern is similar to engulfing candlesticks but comprises of many more bars. If this pattern appears in a downtrend, it is considered a signal to go long or exit a short position. If the pattern becomes visible in an uptrend, you can consider selling a long position or entering a short position.
Longer-term traders can use daily data of a trading week. The pattern occurs when an inside week is followed by an outside week, or engulfing week, comprising of higher highs and lower lows.
Patterns are powerful signals of trend reversal. However, they can produce false signs and must be used in combination with other tools for better predictions.
Open a live account with ADSS.